Reactive Regulation of Wall Street


Introduction

The idea of regulating the banks of Wall Street has been an idea that has been around for nearly a century and still policy makers struggle to find the perfect balance between protecting the average person and giving the banks enough room to push and grow the economy. In this paper I will discuss the reactionary nature of the regulations against the financial industry. I will bring specific examples of when regulation only comes after extreme economic downturn or company misbehavior. Regulation started with the Great Depression in 1929 and has been tweaked and tuned for almost 90 years to the most recent Dodd-Frank Act. I will go into depth about what kind of reactions took place and how some of them potentially set the United States up for future recessions. I will offer solutions to this problem, and I will attempt to offer a permanent fix to a problem that nobody else can seem to fix. Short term fixes are not the answer that this country needs, we need a long term solution to keep the financial industry in check so that the American people are protected.

History of Regulation

The first signs of regulation started in 1933 after the worst economic time period in the history of the United States. The roaring twenties were a time not only for face paced people, but also a fast growing economy. The Dow Jones grew nearly 6 times its value at the beginning of the decade from 63 in 1921 to 381 in September of 1929. This unprecedented growth came to a complete and utter stop on October 28th 1929 when the Dow dropped 13% in one day, and then dropped by 12% the following day according to Elmus Wicker. The slide continued through the summer of 1932 where the Dow closed at 41, the lowest value in the 20th century and 89% lower than its pre-crash high. The stock market crash isn’t the only thing that hit the financial system hard. After the stock market collapse, the banks that had been investing money in the stock market, no longer had the funds to repay those people who had put money in the bank. This resulted in a “Banking Panic”. According to Elmus Wicker a banking panic is “a climate of fear caused by economic crisis or the anticipation of such crisis.” This results in a high number of people wanting to withdraw their bank deposits in cash. Typically a bank only holds a fraction of their deposits and this high number withdrawals so quickly can cause any bank to fail. This banking panic culminated in 1933 when there was a national banking holiday declared and no bank could reopen until it was approved by the government. A well-known fact reiterated by Elmus Wicker states “By 1933, one-fifth of the banks in existence at the start of 1930 had failed.” The Government reacted to this dire situation well, they passed the Glass-Steagall Act that effectively separated commercial banking from investment banking. This seemed like a good idea in 1933 when the Glass-Steagall Act was passed but as the marketplace and the financial system became more advanced over time, the separation of banks became highly controversial. That is why this aspect was repealed in 1999 by the Graham-Leach-Bliley Act. Another important aspect of the Glass-Steagall Act was the establishment of the Federal Deposit Insurance Corporation (FDIC). The FDIC is essentially a pool of money collected from the member banks that insures banks deposits. This was in response to the banks not having enough money to pay back their depositors. The Glass-Steagall Act was extremely important to the future of the United States banking system because it reestablished faith and trust in the system. It provided an almost fail-safe way to provide banking services. Had this Act been a couple of years prior it could have prevented one of the worst economic times in modern history. However regulations on the banking industry were relatively new at this point in history and officials simply did not understand the consequences of what was happening during the build-up prior to the Great Depression.

The Glass-Steagall Act along with the other banking acts of the 1930’s did a good job covering most of the bases with preventing another massive economic meltdown similar to the Great Depression. However in 1933 it is difficult to predict what kind of technology we are going to have in the future. That is why eventually the Glass-Steagall Act placed in 1933 will have loopholes that are found by the big banks in the future. The recession of 1980 and 1981 were not necessarily caused by loopholes in those banking acts but by tight monetary policy due to the incredibly rising inflation of the time. The recession of 1981, prior to 2007, was the worst in United States history. Unemployment levels reached 11% and this was mostly concentrated in the construction and manufacturing sectors of the United States economy. These sectors suffered 22% unemployment and 24% unemployment respectively according to federalreservehistory.org. The inflation of the 1980’s was one of the bigger problems that the U.S. economy faced during this time. However once inflation calmed down, the officials and economists had time to dig into the other problems of the recession. The ever changing inflation rates had taken a toll on the banks who had given long-term, fixed-rate mortgages prior to the inflation rise and were now needing to pay more for their deposits than they were receiving from their mortgages. The Garn St. Germain Depository Act was going to come in and deregulate the banks and essentially “free” them of their required deposit rates. This was a very important aspect of this Act because it is another example of the ongoing back and forth between deregulation and regulation of the banking and financial industries. The act gave permission to banks to pass on their lower rated mortgages to buyers in order to increase profit for themselves and cut costs for themselves. Many of the separate aspects of this act had very close ties with the recession of 2007. For this reason I believe that this act was not necessary and was only done so that bankers could take advantage of the system and attempt to make more profit. The regulations imposed after the Great Depression were needed in order to help prevent another depression and to help pull our country out of the one we were in. This gives valid reasons for regulation. However the Garn St. Germain Depository Act was not done for any of these reasons and it contributed to the worst recession in our country’s history.

Enron is one of the prime examples of company misbehavior in the modern era. Throughout the course of the 1990’s Enron had been seen as one of the best and most innovative companies in the whole world. However in the third quarter of 2001, Enron began to unravel. They took a $544 million hit against their earnings for that quarter and announced a $1.2 billion reduction in equity for its shareholders due to an accounting error. A few week after this news came out Enron restated their books and announced that they overstated their net income by $586 million and understated their debt by $711 million according to the Harvard Business School case Innovation Corrupted: The Rise and Fall of Enron by Malcom Salter. These announcements were an absolute shock to Wall Street and resulted in Enron’s stock tanking. The Enron scandal was a result of several different conflicts of interests. One of them was between the CFO and their off-balance sheet partnerships. Their CFO’s name was Andrew Fastow and he was the one negotiating on both sides of these partnerships. This was a major conflict of interest and according to the Harvard Business School case study on the rise and fall of Enron these “partnerships” are where Enron hid their massive debt from failed investments. Fastow also made incredible amounts of personal money off of these partnerships and reportedly earned $30 million from a single one. Now the next question that must be answered is how there is nobody to double check these massive companies’ balance sheets to make sure that everything adds up? That is where the second conflict of interest comes into play. Arthur Anderson was the account organization for Enron and was in charge of making sure that it was safe for the public to invest in Enron. However Enron paid Arthur Anderson for their business. With Enron being one of Arthur Anderson’s biggest accounts and one of the biggest checks they receive, they were not about to give up their best client by reporting them to the SEC. Arthur Anderson is just as much at fault for the Enron scandal as the rest of the corrupt Enron executives. It was a combination of the corrupt off-balance sheet partnerships, the company telling the public nothing was wrong, and Arthur Anderson not reporting what was actually happening at the company. The response to the Enron scandal was one that directly dealt with the problems of that scandal. The Sarbanes-Oxley Act of 2002 handled the auditing problems that had been seen in several different companies around this time such as Enron and Tyco. This act created a board that was meant to oversee all of the accounting of public companies, this board was called the Public Company Accounting Oversight Board (PCAOB). “The first task of this new board was to implement a second core goal: to enlist auditors to enforce existing laws against theft and fraud by corporate officers.” according to John C. Coates of the Journal of Economic Perspectives. In order to reinforce this new goal the Board created new rules involving auditor-firm relationship, auditor rotation, and corporate whistleblowers. These new rules were aimed at preventing the major conflicts of interest between companies and their auditors. This new board was close to the accounting version of the SEC. The SEC watched over the public companies and the PCAOB watched over the companies that audited them. The Sarbanes-Oxley Act is argued as being too constricting on companies which would result in them not growing as quickly as possible. The opposing argument for this is in the long run being more transparent and less sneaky about financial statements will turn into long term growth by the company and will lessen the risk of being involved in an accounting scandal. The act is something that, if followed, will make the market place a more stable place. However this has not stopped companies within the past 10 years from attempting to get away with fraud. This is something that is just going to happen in our society. There are always going to be corrupt executives that want to find loopholes and get away with making that extra dime.

The 2008 Recession was the worst economic downturn other than the Great Depression in our countries history. As you can see from figure 1, the country experienced roughly half of a depression while going through the recession. There were many people at fault and there are still new facts being learned about what exactly happened today. It all started in about mid 2007 when banks started to realize their mistakes about investing and buying subprime loans and stopped doing so. The already

gr_vs_gd
Figure 1

purchased ones that many mortgage companies and Banks owned began to fail as many of the people who actually owed the money in the loans could not pay their loans back and this resulted in the housing market crash. This effected everybody from high-ranking investment banks such as Merrill Lynch to mortgage giants like Fannie Mae and Freddie Mac. Prior to the 2007 meltdown these companies were making billions of dollars. Their CEO’s making upwards of $20 to $30 million dollars a year. Even just the lowly floor workers of the investment banks were making high 6 figure salaries. The market was booming and it seemed as if nothing could go wrong. But then a perfect storm hit when people actually needed to start paying their loans. Nobody could afford to pay their loans which resulted in the banks not getting any of their money that they originally thought. This caused the banks to spiral because they had stated all of this income from these loans on their balance sheets but that money was nowhere to be found.  In early 2008 two large banks collapsed, Lehman Brothers as well as Merrill Lynch. These banks were bought by other banks for a fraction of the price that they had been worth only days before. When the dust finally settled, the government had to pick up the pieces. On October 4th 2008 the US government issued a $700 billion bailout bill to help the banks recover from their own mistake. This bailout was to be paid by the American citizens through taxes. This was the American people who suffered the most from the banks mistakes, having to pay for it. All of these giant problems that took place in 2007 and 2008 is exactly what President Obama was trying to fix with the Dodd-Frank Act of 2010. There were many aspects of this bill that reacted to the crisis. The first is it tried to enforce and implement new rules and regulations against the financial industry. These rules include tighter control on derivatives, which prior to this bill had very little regulation. The new rules allowed the Federal Reserve to scrutinize non-bank companies harder as well. The Dodd-Frank Act’s more noteworthy addition left the public taxpayers off the hook when it came to bailing companies out. This new power is called the Orderly Liquidation Authority, This is a process stated in the act where if an important non-bank company is on the verge of collapse, it will be placed in the governments hands and the government will unravel the company in a way that protects the US economy from excessive hardship or loss. This will have no excess charge on the taxpayer according to the act itself. The act also requires banks to have a
Contingency plan on what they would do if they fail, these plans must not use any type of extraordinary government support either. The final important aspect of the Dodd-Frank act is the protection that is placed on the mortgage borrower. They are no longer allowed to take out a mortgage if they are not qualified to pay it back. This was a major problem in the creation of the financial crisis because there were people who could not pay back their loans who were taking out more loans just to pay back their other loans. This aspect of the act made it more difficult to attain a loan but with the borrower’s best interest in mind. There were many other key parts to the act that can be seen in figure 2. The Dodd-Frank Act is something that helped fixed the system that clearly had some serious flaws in it. Bu
t it seems that a massive recession like the one in 2008 could have been avoided with only some of the aspects of the Dodd-Frank Act

Dodd-frank
Figure 2

already in place. For example mortgage lending practices should have never been allowed to get as loose as they had been in the years leading up to the financial crisis. This along with taxpayers having to pay for a company bailout are laws that should have been in place years before the crisis
took place. The Dodd-Frank Act did a fantastic job reacting to the crisis but there needs to be some sense of anticipation by lawmakers in order to protect the American people from recessions like the one in 2008.

 

Solutions to Reactive Policy

The examples that have been provided are to create an understanding of the past. When we understand the past it can allow us to look for similar trends that are in the future. The regulations of the financial industry are reactionary, and this has been an ongoing trend that has continued throughout the 20th and the 21st centuries. From as far back as the Great Depression to as recently as the 2008 financial crisis. There is one significant problem that stands in the way of proactive regulation, and that is self-interest. A problem that is something that has plagued the human race for a long time. It is human nature to be selfish and want what is best for yourself rather than what is best for the group. This is what is preventing the financial industry from being regulated in a way that is beneficial for everybody. When the executives of big banks and other big companies want to make more money for themselves, they have the tendency to bend the rules in order to get some cash flowing into their pocket. It is this kind of behavior that disrupts the marketplace and causes economic downturn. That is why I believe that some of my solutions might work. They set the tone for the executives that if they bend the rules in their favor, they will be punished.

Today, our world is being effected in a wide variety of ways by the financial industry. Some areas do not have anything to do with the financial industry, and yet they are still somehow tied to it. For an industry that is involved with so many different aspects of society, one would think that there would be more regulation involved in order to protect the other aspects of society. This can be seen throughout the course of history as I have pointed out in the earlier portion of this paper. The entire system involved with regulating the financial system, is reactionary. There have been almost no examples of proactive regulation of Wall Street. This is caused by people simply not wanting to regulate anything that could make them money. Any sort of proactive regulation results in severe backlash from the financial industry and since they have significant power in all aspects of society, the regulation never ends up getting passed. A prime example of this is an instance referred to in the movie “Inside Job”.  Derivatives were discussed and these derivatives allowed investment banks to essentially gamble on anything. The banks had been doing this for a short time when the government wanted to start regulating the use of derivatives. Brooksly Born was appointed to head the commodity futures trading commission, this oversaw the derivatives market. The derivatives were praised as being good for the market but they were determined to be potentially dangerous. In May of 1998 it was proposed to regulate these derivatives, Brooksly Born received a call very shortly after from Larry Summers (Secretary of the Treasury) saying he had 13 bankers in his office and “he, in a very bullying manner, directed her to stop.” This is an example of the power that the banks have in order to prevent from being regulated. It is this power that promotes the idea of regulation being reactive and not proactive. The banks prevent any sort of proactive regulation because they have the power to control certain aspects of Washington that are involved when passing bills. When the SEC is investigating a big bank for doing illegal things, all that bank has to do is run to the congressmen they fund and tell them to propose a bill to cut the budget of the SEC. This is a large conflict of interest and judging by what has happened with big conflicts of interest in the past, it is bound to end up being a problem. That is where one of my proposed solutions come into play. To help promote security on Wall Street, the SEC needs to receive a specific amount of funds every year. This would be a nonnegotiable number that rises and falls with inflation. This number will obviously need to be higher than it is today. President Obama has tried in recent years to increase funding to the SEC and other financial regulatory agencies but typically those numbers get slashed down to a fraction of the size when going through congress. Setting an exact number would kill the discussion for how much funding the SEC needs. If there is a set number, then the SEC no longer has to worry about losing funding by going after the bigger companies. The other regulatory authorities also need funding, but that can come later after the dust has settled and the SEC returns to being an actual regulatory force on Wall Street.

An alternate solution could be simply providing the regulatory authorities with more power. A system would need to be put in place that would allow the authorities to check on each other. But extra power to these establishments would give them more power to make rules as well as enforce them. These powers would include fines like they do now but also include sending the culprits to prison. This may sound similar to the start of some sort of KGB type police but that is not what I had in mind. The extra power could only be used in dire situations where the authority sees problems that could arise in the future. The derivatives case from “Inside Job” would be another example of how this power could be used to help prevent Wall Street from doing anything dangerous. The new powers would simply bypass the process of working a bill through congress. If the regulatory authorities all agreed that this banking practice could possibly be dangerous in the future, then whatever rules they impose would then be in effect immediately. This would completely eliminate the power that the banks have in congress as well as the power that they have to sway people like Brooksly Born. Giving out power like this could be dangerous though. Given to the wrong group of people, they could control almost every aspect of the financial industry without consent from the government. This hopefully would be prevented by the large number of regulatory authorities that would be involved with every decision. My mental image of this is very similar to the United States government where there are checks and balances to prevent a misuse of power. With the right balance of powers I believe that giving more power to the regulatory agencies could potentially be the answer that solves the problems of reactionary regulations. This allows the authorities to remain flexible and to adjust to new technologies while keeping the power to step up if they are needed. This solution is better than simply placing a single law that only applies to a certain period of time, which is the problem that we have seen in the past. By making the power flexible, it prevents companies from finding loopholes in old plans and taking advantage of the public in doing so. This new power could fill the loopholes as they are being spotted and hopefully prevent future financial collapses. The real problem runs into actually convincing congress, who has large businessmen in their ear, to pass this new power into law. This I believe would be the biggest challenge faced, convincing a conservative that extra power to regulate Wall Street is a good idea is almost impossible. The idea of more Wall Street regulation is a hard policy issue to convince anybody of but in order to stop the trend of a recession every 10-12 years, it needs to be done.

The last and final solution that could possibly help control the financial industry, is to simply put a cap on how much the top level employees can make. Putting a cap on the amount of money that an executive could take home would put less emphasis on making money and more emphasis on doing things the right way. If there was a max salary of $5 million put on all of the executives of major companies then there would be less incentive to bend the rules just to make more money. Again the 2008 financial crisis is another example of when this would have helped. The executives in the years leading up to the financial crisis were making $20 to $30 million, this is all money that could be used to go back into making sure that the company doesn’t collapse. There are a lot of problems with this solution however. The first is making sure these executives are not funneling money to themselves, off the books, in order to make more money individually. There have been scandals of executives doing this when
they are allowed to make as much money as they want, I can only imagine how much of a problem it would be if there was a cap on the maximum salary. That is why this solution would need to be combined with one of the other two solutions I proposed in order to keep an eye on the executives and make sure that they are not cheating the system. The second problem is convincing the American people and congress that this is not socialism. Putting a max salary on a person seems like killing the American dream. The financial system is one of the only systems that has gotten Thdownloade United States in trouble over the last 100 years. That is why they need to be watched and maybe even put a lid on before they get us into any more trouble.

Conclusion

The financial Industry has its problems, we have known that for a long time. Yet we refuse to attempt to fix those any problems in the long term. We are content with only making short term fixes that eventually are out grown by the market and new technology and this creates a new problem. These new problems almost always result in some kind of economic downturn and then we must make another short fix. The solutions I proposed are long term fixes that are flexible and able to change with the world. They will take care of any future problems that may arise and will not disrupt the system in anyway. The solutions are only as an extra safety system to put in place to protect the economy as well as the American people from harm. Looking throughout history there have been countless examples of regulation being reactionary, these solutions are proactive and should be put in place as soon as possible.

 

Bibliography

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Journal of Economic Perspectives, 21(1):91-116.

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Harvard Business School, 2004.

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Images

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Depression.” New York Times (blog), March 20, 2009. Accessed May 9, 2016.                             http://krugman.blogs.nytimes.com/2009/03/20/the-great-recession-               versus-the-great-depression/?_r=0. Photo

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